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Risk Management Fundamentals
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Interest Rate Risk
Interest Rate Risk is the risk where changes in interest rates affect an investment's value. Mitigation strategies include asset-liability matching, duration gap management, and the use of interest rate swaps or options.
Reputation Risk
Reputation Risk is the chance of a negative public opinion that causes a decline in customer base or revenue. Mitigation strategies include maintaining high ethical standards, effective public relations, and crisis management.
Country Risk
Country Risk involves the risk that a country will be unable to meet its financial commitments. Mitigation could involve investment in politically stable countries, insurance, or using credit default swaps (CDS).
Volume Risk
Volume Risk is the risk that a change in volumes bought or sold will affect profits. Companies can hedge against this risk by entering into long-term contracts or using volume-based derivatives such as quantity swaps.
Model Risk
Model Risk arises from the potential for inaccuracy or misuse of financial models in decision making. Mitigation strategies are regular model validation, use of multiple models, and sensitivity analysis.
Systematic Risk
Systematic Risk is the risk inherent to the entire market or market segment. Mitigation strategies include diversification across asset classes and using hedge funds or derivatives to manage unwanted exposure.
Inflation Risk
Inflation Risk is the danger that the cash flow from an investment won't be worth as much in the future because of changes in purchasing power due to inflation. Mitigation includes investing in inflation-protected securities or real assets that tend to appreciate with inflation.
Liquidity Risk
Liquidity Risk refers to the risk that an entity will not be able to meet its short-term financial obligations because it cannot convert assets to cash quickly. This can be mitigated by maintaining adequate cash reserves and managing assets and liabilities.
Strategic Risk
Strategic Risk arises from adverse business decisions or inferior execution of business decisions. Mitigation includes good corporate governance, strategic planning processes, and performance monitoring systems.
Credit Risk
Credit Risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. It can be mitigated by performing credit analysis, diversifying lenders, and purchasing credit derivatives.
Regulatory Risk
Regulatory Risk stems from a change in laws or regulations that could negatively impact a business. Companies can mitigate this risk through active regulatory monitoring, advocacy, and compliance management systems.
Commodity Risk
Commodity Risk revolves around the uncertainty of future market values and the size of future income, caused by fluctuations in the prices of commodities. Firms can mitigate this risk through futures contracts, commodity swaps, and options contracts.
Environmental Risk
Environmental Risk is related to financial losses due to environmental disasters or changes in environmental regulation. Mitigation includes environmental impact assessments, insurance coverage, and investment in sustainable business practices.
Legal Risk
Legal Risk comes from the possibility of legal action affecting the financial health of a company. It can be reduced by ensuring compliance with all applicable laws, thorough contracting, and maintaining robust legal counsel.
Technological Risk
Technological Risk pertains to the potential losses from technology failure or obsolescence. Mitigation strategies include keeping technology up-to-date, investing in research and development, and having robust IT security and backup systems.
Foreign Exchange Risk
Foreign Exchange Risk is the risk of loss due to changes in currency exchange rates. Mitigation can be achieved through hedging strategies using currency forwards, futures, options, or swaps.
Market Risk
Market Risk involves the risk of losses in on and off-balance-sheet positions arising from movements in market prices. The main types are equity risk, interest rate risk, currency risk, and commodity risk. Mitigation can include diversification, hedging strategies, and using market risk metrics like Value at Risk (VaR).
Project Risk
Project Risk includes the potential for failing to meet the goals of a particular project due to various uncertainties. Mitigation techniques involve rigorous project management practices, regular risk assessments, and contingency planning.
Unsystematic Risk
Unsystematic Risk, also known as specific or idiosyncratic risk, is related to a particular company or industry. Mitigation can be done through diversification across a large number of assets or sectors.
Operational Risk
Operational Risk is the risk of loss from inadequate or failed internal processes, people, systems, or from external events. It can be mitigated with good internal controls, insurance, and robust corporate governance practices.
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